This chapter discusses mergers and acquisitions (M&A). It covers key concepts like different types of M&A deals and reasons for them. It also explains accounting practices and defensive tactics. Some reasons for M&A that can benefit shareholders are reducing costs and creating synergies. However, diversification alone does not create value. The chapter outlines methods of M&A, factors in valuing transactions, and evidence on outcomes. It concludes with divestitures and corporate restructurings that change ownership structure.

1. Chapter
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
25
•Mergers and Acquisitions

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Key Concepts and Skills
• Be able to define the various terms
associated with M&A activity
• Understand the various reasons for
mergers and whether or not those reasons
are in the best interest of shareholders
• Understand the various methods for a
paying for an acquisition
• Understand the various defensive tactics
that are available

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Chapter Outline
• The Legal Forms of Acquisitions
• Taxes and Acquisitions
• Accounting for Acquisitions
• Gains from Acquisition
• Some Financial Side Effects of Acquisitions
• The Cost of an Acquisition
• Defensive Tactics
• Some Evidence on Acquisitions: Does M&A
Pay?
• Divestitures and Restructurings

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Merger versus Consolidation
• Merger
• One firm is acquired by another
• Acquiring firm retains name and acquired firm
ceases to exist
• Advantage – legally simple
• Disadvantage – must be approved by
stockholders of both firms
• Consolidation
• Entirely new firm is created from combination
of existing firms

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Acquisitions
• A firm can be acquired by another firm or individual(s)
purchasing voting shares of the firm’s stock
• Tender offer – public offer to buy shares
• Stock acquisition
• No stockholder vote required
• Can deal directly with stockholders, even if management is
unfriendly
• May be delayed if some target shareholders hold out for more
money – complete absorption requires a merger
• Classifications
• Horizontal – both firms are in the same industry
• Vertical – firms are in different stages of the production process
• Conglomerate – firms are unrelated

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Takeovers
• Control of a firm transfers from one group
to another
• Possible forms
• Acquisition
• Merger or consolidation
• Acquisition of stock
• Acquisition of assets
• Proxy contest
• Going private

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Taxes
• Tax-free acquisition
• Business purpose; not solely to avoid taxes
• Continuity of equity interest – stockholders of target
firm must be able to maintain an equity interest in the
combined firm
• Generally, stock for stock acquisition
• Taxable acquisition
• Firm purchased with cash
• Capital gains taxes – stockholders of target may
require a higher price to cover the taxes
• Assets are revalued – affects depreciation expense

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Accounting for Acquisitions
• Pooling of interests accounting no longer allowed
• Purchase Accounting
• Assets of acquired firm must be reported at
fair market value
• Goodwill is created – difference between
purchase price and estimated fair market
value of net assets
• Goodwill no longer has to be amortized –
assets are essentially marked-to-market
annually and goodwill is adjusted and treated
as an expense if the market value of the
assets has decreased

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Synergy
• The whole is worth more than the sum of
the parts
• Some mergers create synergies because
the firm can either cut costs or use the
combined assets more effectively
• This is generally a good reason for a
merger
• Examine whether the synergies create
enough benefit to justify the cost

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Revenue Enhancement
• Marketing gains
• Advertising
• Distribution network
• Product mix
• Strategic benefits
• Market power

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Cost Reductions
• Economies of scale
• Ability to produce larger quantities while
reducing the average per unit cost
• Most common in industries that have high
fixed costs
• Economies of vertical integration
• Coordinate operations more effectively
• Reduced search cost for suppliers or
customers
• Complimentary resources

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Taxes
• Take advantages of net operating losses
• Carry-backs and carry-forwards
• Merger may be prevented if the IRS believes the sole
purpose is to avoid taxes
• Unused debt capacity
• Surplus funds
• Pay dividends
• Repurchase shares
• Buy another firm
• Asset write-ups

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Reducing Capital Needs
• A merger may reduce the required
investment in working capital and fixed
assets relative to the two firms operating
separately
• Firms may be able to manage existing
assets more effectively under one umbrella
• Some assets may be sold if they are
redundant in the combined firm (this
includes human capital as well)

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General Rules
• Do not rely on book values alone – the
market provides information about the true
worth of assets
• Estimate only incremental cash flows
• Use an appropriate discount rate
• Consider transaction costs – these can
add up quickly and become a substantial
cash outflow

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EPS Growth
• Mergers may create the appearance of
growth in earnings per share
• If there are no synergies or other benefits
to the merger, then the growth in EPS is
just an artifact of a larger firm and is not
true growth
• In this case, the P/E ratio should fall
because the combined market value
should not change
• There is no free lunch

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Diversification
• Diversification, in and of itself, is not a
good reason for a merger
• Stockholders can normally diversify their
own portfolio cheaper than a firm can
diversify by acquisition
• Stockholder wealth may actually decrease
after the merger because the reduction in
risk in effect transfers wealth from the
stockholders to the bondholders

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Cash Acquisition
• The NPV of a cash acquisition is
• NPV = VB* – cash cost
• Value of the combined firm is
• VAB = VA + (VB* - cash cost)
• Often, the entire NPV goes to the target
firm
• Remember that a zero-NPV investment is
also desirable

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Stock Acquisition
• Value of combined firm
• VAB = VA + VB + ∆V
• Cost of acquisition
• Depends on the number of shares given to the target
stockholders
• Depends on the price of the combined firm’s stock
after the merger
• Considerations when choosing between cash
and stock
• Sharing gains – target stockholders don’t participate in
stock price appreciation with a cash acquisition
• Taxes – cash acquisitions are generally taxable
• Control – cash acquisitions do not dilute control

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Defensive Tactics
• Corporate charter
• Establishes conditions that allow for a
takeover
• Supermajority voting requirement
• Targeted repurchase aka greenmail
• Standstill agreements
• Poison pills (share rights plans)
• Leveraged buyouts

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More (Colorful) Terms
• Golden parachute
• Poison put
• Crown jewel
• White knight
• Lockup
• Shark repellent
• Bear hug
• Fair price provision
• Dual class capitalization
• Countertender offer

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Evidence on Acquisitions
• Shareholders of target companies tend to earn excess
returns in a merger
• Shareholders of target companies gain more in a tender offer
than in a straight merger
• Target firm managers have a tendency to oppose mergers, thus
driving up the tender price
• Shareholders of bidding firms earn a small excess return
in a tender offer, but none in a straight merger
• Anticipated gains from mergers may not be achieved
• Bidding firms are generally larger, so it takes a larger dollar gain
to get the same percentage gain
• Management may not be acting in stockholders’ best interest
• Takeover market may be competitive
• Announcement may not contain new information about the
bidding firm

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Divestitures and Restructurings
• Divestiture – company sells a piece of itself to
another company
• Equity carve-out – company creates a new
company out of a subsidiary and then sells a
minority interest to the public through an IPO
• Spin-off – company creates a new company out
of a subsidiary and distributes the shares of the
new company to the parent company’s
stockholders
• Split-up – company is split into two or more
companies and shares of all companies are
distributed to the original firm’s shareholders

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Quick Quiz
• What are the different methods for achieving a
takeover?
• How do we account for acquisitions?
• What are some of the reasons cited for mergers?
Which may be in stockholders’ best interest and
which generally are not?
• What are some of the defensive tactics that firms
use to thwart takeovers?
• How can a firm restructure itself? How do these
methods differ in terms of ownership?

24. Chapter
McGraw-Hill/Irwin Copyright © 2006 by The McGraw-Hill Companies, Inc. All rights reserved.
25
•End of Chapter